Trickle-Up Economics

January 3rd, 2012 at 10:19 pm

Based on a spate of recent posts (see here and links therein), a commenter (HT: Greg) asks a good, tough question of yours truly: on the one hand, I’ve argued long and hard that while we definitely need more progressive tax policies, the fact that the growth of inequality is largely a pretax phenomenon implies that tax changes alone won’t reverse the trend.

Yet, in this post reviewing the recent CRS inequality report, I point out that a) the increase in capital gains plays a large role in driving inequality trends, and b) if we taxed such gains as regular income (instead of at much reduced rates), that would help to reduce inequality.

So how can I argue on the one hand that tax policy is inherently limited as a tool against rising inequality, and on the other, that we should employ tax policy to push back on inequality?

I could invoke Walt Whitman: “Do I contradict myself? Very well, then I contradict myself, I am large, I contain multitudes”—and leave it at that.

But better yet, let me explain. First, the evidence as shown in the chart here shows that increased inequality is a pretax story. Whether it’s the increase in earnings or wealth inequality, the latter including outsized gains from assets, that’s all occurred in the so-called primary distribution of income, before taxes and transfers get into the mix.

Now, that doesn’t mean that more progressive taxes and transfers can’t help offset higher inequality. They can, they should, and they do. Unfortunately, as I stress here, they’ve become less effective in that regard over time.

But there’s another policy constraint here—it’s the “building-a-dam-against-an-ever-rising-river” problem. As long as market outcomes become increasingly unequal almost every year, whatever redistribution we’re accomplishing through the tax code will have to be constantly ratcheted up. That’s tough even in a rational political environment—it’s impossible in the current one.

Then there’s the question of how much of a direct difference we could make in the growth of inequality by just depending on taxes (the word “direct” is important, as I’ll show in a moment). Using table B-1 from the CRS report, I can simulate what the Gini index might have been in 2006 if the tax system hadn’t become less progressive. And the answer is: it wouldn’t have directly changed measured inequality much at all—it lowered the Gini by only 0.005 compared to its actual 2006 level.* More progressive taxation will help, but at the end of the day, you can’t bring a knife to a gun fight.

There are, however, very good indirect reasons to think that taxes matter a lot more in terms of moving inequality than the above rap would suggest, and I should be more careful to reflect this insight. Important work on this question by Saez et al (see here; paper here), for example, shows strong correlations across time and place between higher marginal tax rates and reduced income concentration.

With higher taxation, they argue, there’s less “rent seeking” (economese for rich people figuring out ways to claim more riches—ways that don’t lead to better overall economic outcomes). As Saez et al put it, “Lower top tax rates induce top earners to bargain more aggressively for higher pay” and bargaining here mean using their clout, power, friends on the board, etc., to claim pay packages that go well beyond their productive contributions to the firm’s output. This is a classic zero-sum outcome–the execs’ gain is someone else’s loss.

Of course, the notion that there’s separable independence between the primary distribution (market outcomes) and the secondary (post-tax and transfer) is wrong. Tax policy itself affects market outcomes, for better or worse.

The trickle-downers have way overdone this for decades, arguing, against evidence to the contrary, that tax cuts unleash torrents of growth. What Saez et al are identifying is a new pattern that looks like it has a lot to do with inequality: trickle-up economics.

*I did this by substituting the 1996 terms for taxes into the 2006 table and recalculating the Gini index. One wrinkle here is that you have to rescale the income shares so that they sum to one.

13 comments in reply to "Trickle-Up Economics"

Wow. Very cool. Thanks for the clarification, Dr. Bernstein. This is excellent. (Although I wonder what CRS would have found if the data set compared 1976 – 2006, instead of 1996 – 2006. But the Saez paper was pretty cool in that regard.

Anyway, it looks like Saez gave you and Paul Krugman a shout out at the very end of his paper, “… social perceptions are likely to further widen the differences in the socially desired level of top earners taxation across the different models relative to our analysis with zero welfare weights. It is also possible that higher income shares raise the ability of top income groups to influence social perceptions (e.g. by funding think tanks or medias that are more pro-rich), thereby creating some reverse causality between income inequality, perceptions and policies. Economists can play a key role in enlightening those perceptions by evaluating empirically which economic model of top incomes determination accounts best for the facts.”

Keep up the good work Dr. J, because the Koch brothers and the swells at AEI, CATO and Heritage are doing all they can “to influence social perceptions (e.g. by funding think tanks or medias that are more pro-rich), thereby creating some reverse causality between income inequality, perceptions and policies.”

Could the Capital Gains Tax be structured so that investment that creates jobs and growth [eg heavy equipment] is taxed at the 15% rate, and investment that is passive, as in securities, etc, is taxed at the ordinary income rate? And additionally, the tax rate on Carried Interest could be calculated as ordinary income. Could that combination of changes tend to induce growth while positively affecting [ie equalizing] wealth distribution?

I think this is a very good post, and gets at the issue that high tax rates for very high incomes would change behavior. At incomes over $1 million, earning more income is all about gaining status. Ideally, instead of the status game of the rich and powerful being about having the biggest Forbes ranking, it would be about something that is better for the economy.

-“But there’s another policy constraint here—it’s the “building-a-dam-against-an-ever-rising-river” problem. As long as market outcomes become increasingly unequal almost every year, whatever redistribution we’re accomplishing through the tax code will have to be constantly ratcheted up. That’s tough even in a rational political environment—it’s impossible in the current one.”

No doubt its a heavy lift; probably impossible the way we’re approaching it. But why is the “default” position to just let this wealth and income concentration continue unabated while we try to figure out how to “tweak” the tax code? The government is heavily involved in the pre-tax distribution and politically constrained from correcting the disparities through tax policies (although we could tie marginal tax rates rates to wealth and income Ginis to make it automatic if we took the wealth concentration problem seriously). This is precisely why we need wealth and steep inheritance taxes to correct in situations like the current one when we got it so seriously wrong that our policies combined to produce an aristocracy that is now trying (and largely succeeding) to protect its wealth in perpetuity by controlling our government with their wealth.

-“More progressive taxation will help, but at the end of the day, you can’t bring a knife to a gun fight.”

Our wealth Gini was .84 before the real estate fraud and is likely to be considerably worse when that destruction to middle class wealth is known and accounted for. IMHO we should be discussing how wealth and inheritance taxes should be implemented, not if they should.

I would be interested to learn what would happen to the Gini coefficient were capital gains and qualified dividends treated as earned income for Social Security taxation purposes (and you’d have to get rid of the $106,800 cap as well).

Getting rid of the cap alone would tweak Social Security’s balance sheet enough to make it sustainable for 75 years, and taxing capital gains and dividends may add enough surplus to warrant discussion of raising Social Security benefits.